Exploring passive/managed index funds

The vast majority of unit trust investment funds available to retail investors are actively managed. The fundamental philosophy supporting active management is that markets are inefficient and the market price of a security does not reflect it's true worth. Active managers' investment processes and philosophies are formulated around finding perceived mispricing in the market, buying assets, and holding them within their portfolio as their value increases over time. These active managers will undertake in-depth company, industry, and economic research when choosing securities with the primary goal of generating returns in excess of the market (alpha) and protecting capital losses in adverse market conditions. The results of their research will assist them in formulating what they believe is a fair price for a security. If the price they calculate is above the market price of the security, they will look to buy the security to exploit transactions perceived to be profitable in the long term.

In contrast to active management, we have passive management and index tracking. Passive management is an investment strategy based on limited buying and selling transactions. Managers will compile a portfolio and execute very few buy or sell transactions, thereby limiting activity on the instruments held. Due to the limited transacting conducted within these portfolios their costs tend to be lower than that of actively managed funds.

Index tracking is based on an investor "buying the market", for example the JSE All Share Index (J203t). This method of investing is based on The Efficient Market Hypothesis (EMH), which states that it is impossible to "beat the market" as all relevant information has already been taken into account when calculating the market value of a security. According to the EMH there are no "cheap" or "expensive" securities as the prices of all securities are always at "fair value". The fundamental principle of these funds is that they will aim to replicate, but not beat, the performance of a chosen index, regardless of market conditions. These index funds will also traditionally be more competitively priced than actively managed funds.

Types of index funds

Although index funds are passively managed, there are various types of indices that are replicated by these funds. Market cap-weighted index funds have been the norm in the industry, but alternative weighting funds (RAFI and "Smart beta") have become more prevalent of late. Knowledge of these indices is just as important as understanding the investment philosophy of an active manager.

Market capitalisation index trackers: These funds will invest in securities as per their weighting within the specified index. Typical examples of indices tracked include the FTSE/JSE Top 40 Index (J200t), the FTSE/JSE All Share Index (J203t), and the FTSE/JSE SA Listed Property Index (J253t).

RAFI 40 index trackers: The underlying securities of these funds are non-market capitalisation weighted, but weighted using the Fundamental Indexation MethodologyTM developed by Research Affiliates LLC. The index consists of 40 stocks determined by fundamentals of the individual companies according to book value, cash flows, dividends, and sales. The RAFI methodology is comparable to active management whereby the stocks are chosen from a bottom-up quantitative basis. The methodology seeks to reduce a bias towards shares with a large market capitalisation and include a more diversified collection of companies. Due to the factors incorporated in the RAFI methodology, investors could be exposed to a collection of companies, which could vary from large cap, mid cap, defensive, cyclical, and high dividend yielding stocks.

"Smart beta" index funds: These funds are passively managed and track a predetermined index. Unlike market capitalisation weighted index trackers, their tracking target and security allocation replicates a predetermined style or methodology. Examples of indices tracked are: FTSE/JSE Dividend Plus index (J259t) and The Equally Weighted Top 40 Index (J110t).

Risks and benefits of indexing investments

While most active managers describe risk as loss of capital or volatility, index funds define risk as "tracking error," or their deviation from their performance target. The biggest risk of investing in index tracking funds is being exposed to full market risk. The fund will seek to be 100% invested in the index at all times, exposing investors to full market volatility.

One of the major benefits of passive/index funds is the low annual management fee when compared with active managers. The low management fee is a function of the fund being purely passive and not having to employ qualified investment professionals to continually select investment instruments. Another benefit is that investors can have peace of mind with regards to transparency, and the systematic investment process of index funds.

Considerations when evaluating an index fund

As index funds do not aim to deliver an absolute return number, it is more prudent to analyse their statistical risk measures as opposed to their returns. Measures such as beta, tracking error, and R-squared will indicate how closely the fund tracks its desired index. Another important consideration is the administrative and implementation abilities of a management company, as any delay in actioning trades could reflect in the statistical measures. Generally, index funds will only transact due to certain occasions, namely: quarterly rebalancing, cash in- and outflow management, and corporate actions. However, the most important factor when evaluating an index fund is the management fee and total expense ratio (TER). A high management fee can erode investment returns even though the statistical measures look attractive.

Exchange Traded Funds vs Index unit trust funds

Exchange traded funds (ETFs) and index tracking unit trust funds are both collective investment schemes whereby investors can purchase a participatory stake and share in the performance thereof. Both vehicles will attempt to perfectly track the desired index, but the key difference lies in how these vehicles are priced and administered. ETFs are listed on a registered stock exchange and are priced intra-day, while index unit trusts are not listed and are only priced once a day. Basically, an ETF will have a different price during the course of the day allowing investors to take advantage of price swings, while the index unit trust will have one price reflecting the nett effect of the day's movements. ETFs are generally available via stockbrokers, while unit trust funds are available directly from the management company or via an investment platform.

With an increasing emphasis on fees and overall costs to client, passive funds offer an attractive alternative when compared to traditional actively managed funds. With the advent of new passive strategies, investors can invest in various types of passive styles to diversify their investment portfolio. However, with greater choice comes great chance of confusion. Investors need to understand that choosing an alternative weighting fund is an active decision and can lead to a sector or style bias. Just as it is important to understand the style of an actively managed fund, investors need to understand the index their fund is trying to replicate and the factors which could affect their investment experience.